ETFs

1. Introduction to Exchange Traded Funds (ETFs)

In this lesson, we’ll dive into the concept of Exchange Traded Funds, commonly known as ETFs, and explore how they function. ETFs are often seen as a major innovation in the world of finance, much like how smartphones revolutionized the tech industry. The introduction of ETFs sparked a wave of new financial products that became incredibly popular among investors.

Key Points:

• Origins: The first ETF was created by the Toronto Stock Exchange in Canada in 1990.
• Growth: In the U.S. market, the value of ETFs skyrocketed from $100 billion in the early 2000s to $3.4 trillion by 2017. Globally, around $4.5 trillion is invested in ETFs.
• Popularity: ETFs have grown in popularity primarily due to their low fees and ease of access, which has led them to capture market share from traditional mutual funds.

Advantages of ETFs:

• Lower Fees: ETFs generally have lower fees because they incur lower operational costs.
• Tax Efficiency: The structure of ETF transactions can avoid certain taxes that mutual funds typically pay.
• Passive Management: Most ETFs use passive investment strategies, meaning less frequent trading and lower transaction costs.

As we proceed, we’ll discuss other cost-saving features of ETFs and delve deeper into how they operate.

2. Shortcomings of Mutual Funds

Let’s revisit some of the drawbacks of Open-End and Closed-End Mutual Funds.

Open-End Mutual Funds:

• Cash Reserve: Open-End Mutual Funds often need to keep a portion of their assets in cash to allow investors to withdraw funds on any given day. This requirement can dilute the fund’s overall performance.
• Investment Limits: These funds may restrict the number of times you can invest or withdraw within a specific period, such as 90 days.
• Pricing Issues: The price you receive when withdrawing funds is based on the closing price at the end of the day, not the price at the exact moment you initiate the transaction.

Closed-End Mutual Funds:

• Market Divergence: While Closed-End Mutual Funds allow their shares to be traded on the stock market, the market value of these shares can diverge from the value of the underlying portfolio.

The ETF Solution:

ETFs offer solutions to many of these shortcomings:

• No Cash Reserve Needed: Unlike Open-End Mutual Funds, ETFs do not need to hold cash reserves for withdrawals.
• Tradeable Shares: Like Closed-End Mutual Funds, ETF shares can be traded on a stock exchange, but with the added benefit that the market price of an ETF closely tracks the value of its underlying portfolio.

In the following sections, we’ll explore why ETFs can achieve this close tracking and how they offer a more efficient investment vehicle compared to traditional mutual funds.

3. ETFs and Commodities

ETFs are versatile tools that can be used for various investment strategies, including commodities, international stocks, and hedging.

Commodities and ETFs:

Commodities are raw materials that are interchangeable, like oil, gold, or corn. Unlike a unique item like a handmade wedding dress, one barrel of oil is the same as another barrel of oil. This interchangeability makes commodities ideal for trading. ETFs make it easier to invest in commodities without dealing with the physical goods. For example, instead of buying gold and storing it, you can invest in a gold ETF that tracks the price of gold.

4. Commodity Futures

Investing directly in commodities often involves using futures contracts. A futures contract is an agreement to buy or sell a commodity at a fixed price on a future date. Here’s how it works:

1. Entering a Futures Contract: Suppose you enter a futures contract to buy one metric ton of cocoa in six months. You are “long” on cocoa, expecting the price to rise, while the seller (e.g., a farmer) is “short,” expecting the price to fall or stay the same.

2. Closing the Position: Before the contract’s due date, you can “close” your position by entering a new contract to sell the same amount of cocoa at the same price and date. This offsets your initial position, and the exchange manages the transaction.

3. Rolling Over a Contract: If you want to extend your investment beyond the contract’s end date, you can “roll over” the contract. This involves canceling the current contract and entering a new one for a later date.

5. Commodity ETFs

Managing multiple futures contracts can be complex, especially when dealing with different due dates. If you forget to cancel or roll over a contract, you might be required to buy the actual commodity, whether it’s oil, gold, or even livestock!

Commodity ETFs simplify this process. These ETFs handle the buying, selling, and rolling over of futures contracts on your behalf. For example, a gold ETF will manage the futures contracts for gold, so you can invest in gold without worrying about contract dates. You simply buy and hold shares of the ETF as long as you wish.

6. International ETFs

Investing in international stocks through ETFs is also more convenient than direct foreign investments.

Challenges with Direct Foreign Investments:

• Brokerage Accounts: You’d need a brokerage account in the country where you want to invest.
• Time Zone Differences: Trading in foreign markets requires you to be active during their market hours, which can be inconvenient if you live in a different time zone. For instance, trading Hong Kong stocks from New York could disrupt your sleep schedule.

Solution with International ETFs:

Financial firms offer International ETFs that allow you to invest in foreign markets while trading on your local exchange. For example, the iShares China Large-Cap ETF (FXI), issued by BlackRock, tracks the 50 largest companies listed on the Hong Kong Stock Exchange, including Tencent and China Construction Bank.

With FXI, you can invest in Chinese stocks during U.S. market hours, giving you the flexibility to maintain your regular routine, whether that’s getting a good night’s sleep or enjoying time with friends.

7. Using ETFs for Hedging

Hedging with ETFs is a strategy that allows investors to reduce their exposure to market risks. Hedging generally means entering into a transaction to offset potential losses in another investment. Here’s how it works with ETFs:

Example: Hedging with the S&P 500

• Portfolio Exposure: Imagine you have a portfolio filled with stocks from the S&P 500 index. If the overall market declines, your portfolio’s value will likely decrease as well.
• Shorting an ETF: To hedge against this risk, you can take short positions in an ETF that tracks the S&P 500, such as the SPDR S&P 500 ETF (commonly referred to as “spider”). Shorting means you profit when the price of the ETF decreases. If the market drops, your short position gains value, which helps offset the losses in your portfolio.
• Market Movement: However, if the market rises, your long positions in the portfolio will gain value, but your short position in the ETF will lose value, reducing your overall gains.

Sector-Specific Hedging:

• Active Managers: Fund managers may also use ETFs to hedge specific sectors or industries. For instance, if a portfolio is heavily invested in tech stocks, a manager might short the Fidelity MSCI Information Tech ETF to reduce exposure to the tech sector’s volatility.

8. Understanding ETF Sponsors

ETF Sponsors are financial institutions that create and manage ETFs. These sponsors are responsible for designing the ETF portfolio, issuing shares, and maintaining the fund. Some of the largest ETF sponsors include:

Major ETF Sponsors:

• BlackRock’s iShares: The largest ETF sponsor, originally created by Barclays’ Global Investors and later acquired by BlackRock. By early 2018, iShares managed over $1.75 trillion in assets, accounting for more than a quarter of BlackRock’s total assets under management (AUM).
• Other Major Sponsors: Vanguard, State Street Global Advisors (which issues the SPDR ETFs), Deutsche Bank, and Invesco.

How ETF Sponsors Earn Money:

• Fee Structure: ETF sponsors earn fees as a percentage of the assets they manage. For example, if an ETF sponsor manages $1 billion in assets and charges a 0.1% annual fee, they would earn $1 million per year.
• Comparison to Mutual Funds: Although ETF fees are typically lower than those charged by mutual funds or hedge funds, the massive volume of assets in ETFs makes them highly profitable for sponsors.

In essence, ETF sponsors play a crucial role similar to fund managers in mutual funds, but with a focus on maintaining a lower-cost investment vehicle.

Lower Operational Costs and Taxes in ETFs

One of the key advantages of ETFs over traditional mutual funds is their lower operational costs and tax efficiency. Let’s break down why this is the case:

Tax Efficiency in ETFs:

• Creation and Redemption Process:
  • When ETF shares are created, the ETF sponsor does not deal with cash directly. Instead, the sponsor receives a bundle of stocks equivalent to the value of the ETF shares they are creating.
  • During the redemption process, the ETF sponsor gives a bundle of stocks in exchange for the ETF shares, again, of equal value.
  • No Capital Gains: Since the items exchanged (ETF shares and the stock bundle) are of equal value, no capital gain is recorded. This is crucial because capital gains are subject to taxes, and avoiding them reduces the tax burden.

Comparison with Open-End Mutual Funds:

• Cash Transactions: When an investor in an open-end mutual fund wants to withdraw their investment, the fund may need to sell some of its stocks to generate the necessary cash.
• Capital Gains Tax: The sale of these stocks can trigger capital gains, which are taxed by the government. These taxes increase the operational costs of the mutual fund.
• Higher Fees: The higher operational costs due to taxes and other factors are typically passed on to investors in the form of higher fees. This is one reason why mutual funds often have higher fees compared to ETFs.

In summary, the structure of ETFs allows them to avoid many of the capital gains taxes that mutual funds incur, leading to lower operational costs and, ultimately, lower fees for investors.

9. Understanding Arbitrage through a Farmer’s Market

A Simple Example of Arbitrage:

In the example with Betty at the farmer’s market, arbitrage is demonstrated through a basic scenario:

• Market Observation: Betty notices that one farmer, Brock, sells individual oranges for $1 each, while another farmer, Cindy, sells a bag of 10 oranges for $9.
• Arbitrage Opportunity: The price difference presents an opportunity. Betty can buy a bag of 10 oranges from Cindy for $9 and then sell each orange individually for $1, earning $10 in total. This results in a profit of $1 ($10 earned minus the $9 spent).
• Execution: To avoid risk, Betty first secures customers who are willing to buy the oranges at $1 each. Then, she buys the bag of oranges from Cindy and immediately sells them to the customers, ensuring she doesn’t end up with unsold oranges.

This simple example illustrates the concept of arbitrage: buy low, sell high, simultaneously, to make a profit from price discrepancies in the market.

10. Arbitrage in the Financial Markets

Arbitrage and ETFs:

In financial markets, the concept of arbitrage also plays a crucial role, especially in the creation and redemption of ETF shares.

• Arbitrage Pricing Mechanism: Authorized Participants (APs) monitor the market for discrepancies between the price of an ETF and the value of the underlying assets it represents (called the Net Asset Value, or NAV).

  • Creating ETF Shares: If the ETF shares are priced higher than the NAV of the underlying assets, an AP can buy the underlying assets, create new ETF shares, and sell them at the higher price. This action helps bring the ETF share price down closer to the NAV.

  • Redeeming ETF Shares: Conversely, if the ETF shares are priced lower than the NAV, an AP can buy the ETF shares, redeem them for the underlying assets, and sell those assets for a profit. This helps push the ETF share price up closer to the NAV.

Why APs Engage in Arbitrage:

• Profit Incentive: Unlike ETF sponsors, APs don’t earn a fee for creating or redeeming ETF shares. Instead, they profit from the price discrepancies they correct. By engaging in arbitrage, they can make a profit without taking on significant risk, as they are buying and selling at nearly the same time.

• Market Alignment: The actions of APs in performing arbitrage help ensure that the price of an ETF stays closely aligned with the value of the underlying assets, benefiting all investors in the ETF by maintaining fair pricing.

In summary, arbitrage is a critical mechanism that helps keep financial markets efficient, whether in a simple setting like a farmer’s market or in complex financial instruments like ETFs. It allows investors to exploit price discrepancies and ensures that asset prices reflect their true market value.

11. Misaligned ETF Pricing and Arbitrage Opportunities

Understanding ETF Pricing and Arbitrage:

• ETF Premiums and Discounts:
  • ETFs can trade at prices different from the Net Asset Value (NAV) of their underlying assets. When ETF shares are priced higher than the NAV, they are said to be trading at a premium. Conversely, when ETF shares are priced lower than the NAV, they are trading at a discount.
  • Basis Point: The difference between the ETF share price and the NAV is often measured in basis points. One basis point equals 0.01%, or 1/10,000.

Example: iShares STOXX Europe 600 Retail ETF

• Scenario:
  • The iShares STOXX Europe 600 Retail ETF (UCITS) tracks European retail companies like Inditex (Zara) and H&M. This ETF is tradable on the Bolsa Mexicana de Valores, Mexico’s largest stock exchange.
  • Suppose Mexican investors are highly interested in European retail companies, driving up the demand and price of the ETF shares. This creates a premium, meaning the ETF shares are more expensive than the NAV of the underlying stocks.

12. Realigning ETF Share Prices through Arbitrage

The Role of an Authorized Participant (AP):

• Arbitrage Opportunity:

  • An AP, such as Morgan Stanley, might notice the price discrepancy and see an opportunity for arbitrage.
  • Creation Process: To exploit this, the AP buys shares of the underlying companies in the ETF (like Inditex and H&M) at their current market prices.
  • The AP then delivers this bundle of stocks to the ETF sponsor (iShares) in exchange for new ETF shares.

• Impact on Market Prices:

  • Stock Prices: The large purchase of stocks by the AP increases the prices of the underlying stocks.
  • ETF Share Price: The newly issued ETF shares are sold on the market by the AP, increasing the supply and helping to bring down the ETF share price closer to its NAV.
  • AP Profit: The AP profits from the difference between the cost of buying the stocks and the price at which they sell the ETF shares.

Continuous Realignment:

• As long as there is a significant enough price discrepancy between the ETF shares and the underlying assets, APs will continue to engage in this buy-low, sell-high process. This arbitrage activity ensures that the ETF share prices remain aligned with the NAV, maintaining market efficiency.

This process of creating and redeeming ETF shares not only allows APs to profit but also ensures that the ETF prices reflect the true value of their underlying assets, benefiting all investors.